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Should Microsoft Sell Xbox Entertainment Studios?

Microsoft's (NASDAQ: MSFT) closure of Xbox Entertainment Studios appeared to be the end of the company's ambitious efforts to bring original video content to the Xbox One.

The 200-person studio, headed by ex-CBS executive Nancy Tellum, was founded in 2012 by former CEO Steve Ballmer. The business was shuttered as part of the company's layoff of 18,000 employees in July. With the exception of Halo: Nightfall and Quantum Break, most of the projects were presumed dead.

Halo: Nightfall. Source: Microsoft.

However, a recent report from The Hollywood Reporter indicates that Microsoft could sell the business to Time Warner (NYSE: TWX) instead. The report claims that Xbox Entertainment Studios could merge with Machinima, the gaming-centered YouTube channel which Time Warner invested $18 million in. If Warner saves Xbox Entertainment Studios, previously planned projects like Fable, Age of Empires, Forza, and Gears of War could still see the light of day.

If Microsoft were to sell Xbox Entertainment Studios to Time Warner, what would both companies gain from the deal?

Why Microsoft should sell Xbox Entertainment StudiosMicrosoft's biggest mistake with the Xbox One was to position it as an all-in-one media center for the living room. The strategy, which initially centered around the Kinect, caused the console to debut at $499 -- $100 more than Sony's (NYSE: SNE) PS4. Microsoft eventually removed the Kinect to match the PS4's price, but it was too late -- Sony gained the early lead, and recently announced that it sold 10 million consoles compared to Microsoft's 5 million Xbox Ones.

Xbox Entertainment Studios was a big part of that misguided strategy. Sony can easily afford to add original content to the PS3 and PS4, since it owns record labels, TV stations, and film studios. Microsoft started from scratch in hopes of matching the original content that Sony could easily churn out at its TV and film studios.

Microsoft's strategy made sense on paper -- it would produce original content which tied into its games. Halo: Nightfall, produced by Ridley Scott, would introduce gamers to Agent Locke, a playable character in Halo 5: Guardians. Remedy's Quantum Break would be the first game to interact with a companion TV show, although the exact methods have yet to be revealed. These plans were ambitious, but the shows would have gained more exposure on network or cable TV instead of the Xbox One.

This means that all of these devices might eventually run on a single Windows operating system, similar to Android. But for now, it means tethering all of these systems to a single ecosystem with services like OneDrive and Bing. That's why Microsoft axed the Nokia Android phone, Asha, and S40 devices -- they didn't advance the One Windows strategy in any way.

Xbox Entertainment Studios doesn't fit into the One Windows philosophy either -- it's simply an extension of the Xbox business that makes the struggling segment even more top heavy. The Xbox division generated $8.6 billion in revenue in fiscal 2014, a 22% increase from 2013, but it's unclear how much money the business actually loses. Nomura Securities analyst Rick Sherlund suggested last November that Microsoft actually loses around $2 billion annually on the Xbox, but the losses are hidden behind patent royalties from Android devices.

An IHS iSuppli teardown revealed that the Xbox One, minus the Kinect, costs about $396 to manufacture. This means Microsoft takes big losses with new bundles, like the $400 Sunset Overdrive bundle which will arrive on October 28. Microsoft needs to sell more consoles to recoup those losses with its cut of software revenue.

Xbox Entertainment Studios doesn't help expand the Windows ecosystem, and it doesn't help sell consoles. Therefore, it was a smart move to scrap the business before it got out of hand.

What if Time Warner buys Xbox Entertainment Studios?Of course, it would be smarter to sell the division instead of simply shutting it down. If Time Warner buys the business and integrates it into Machinima, it could help the YouTube channel evolve to the next level with exclusive content like Halo: Nightfall.

Since both the Xbox One and PS4 can play YouTube out of the box, console gamers can still watch the programs on their consoles. Microsoft gets cross-platform exposure, possible licensing fees, and lets Warner Bros., with its more extensive studio operations, develop the shows and films.

Since Time Warner also owns HBO, the Turner cable networks, and CW (a joint venture with CBS), it could launch a Halo series on primetime TV as well -- something that Microsoft reportedly considered with the second Steven Spielberg-produced Halo series. We might even get an epic, Game of Thrones meets Monty Python take on Fable.

The deal would be a win-win situation for both parties -- Microsoft takes some weight off the Xbox division's bottom line and gains better exposure for its franchises, while Time Warner gains new IPs to make new shows and films.

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